Accounting Ratios — Notes

An accounting ratio expresses the relationship between two related figures from the financial statements (for example current assets and current liabilities). Ratio analysis means computing such ratios, comparing them (with past years, with other firms, with accepted standards) and interpreting them.

Forms: pure ratio (2 : 1), times (10 times), percentage (25%).

Objectives and advantages:

• to judge liquidity (short-term paying capacity) and solvency (long-term soundness);
• to measure efficiency in using inventory, receivables and assets, and profitability;
• to summarise many figures in a few relationships that are easy to communicate;
• to make inter-period and inter-firm comparison possible and to help in planning and forecasting;
• to point out weak areas that need management action.

Classification (by purpose): liquidity, solvency, activity (turnover) and profitability ratios.

Definitions. The table sets out what each base means in this chapter, and the second table gives all seventeen formulas. Note especially:

• Debt is the non-current liabilities only; current liabilities never enter solvency ratios.
• Capital employed can be worked out from either side of the balance sheet; the two answers must be equal, which is a useful check.
• Operating expenses do not include finance costs or non-operating losses (loss on sale of a fixed asset, loss by fire); non-operating income (interest or dividend received, profit on sale of an asset) is also left out of operating profit.
• When credit revenue or credit purchases are not given, the total figure is used; when only closing figures are given, they replace the average.

Rounding rule. Ratios are worked to two decimal places, rounded half up (1.2667 → 1.27; 6.125 → 6.13). An exact result is written as it is (2.5 : 1, 25%). Write liquidity and solvency ratios as "x : 1", turnover ratios and interest coverage in "times", and profitability ratios as percentages.

Current ratio = current assets ÷ current liabilities. Conventional level 2 : 1. A low ratio warns of difficulty in paying dues; a very high one suggests idle cash, excess stock or slow collection.

Quick (liquid) ratio = quick assets ÷ current liabilities, where quick assets = current assets − inventories − prepaid expenses. Conventional level 1 : 1. It tests whether dues can be met without depending on the sale of stock.

Effect of a transaction: recompute both parts. Rules that follow from the arithmetic (check them on the table):

• an equal rise in both parts lowers a ratio above 1 and raises a ratio below 1;
• an equal fall in both parts raises a ratio above 1 and lowers a ratio below 1;
• an exchange of one current asset for another leaves the current ratio unchanged (but cash for inventory lowers the quick ratio).

Debt-equity ratio = debt ÷ equity (debt = long-term borrowings + long-term provisions; equity = shareholders' funds). A low ratio means a larger safety margin for lenders; a high ratio means heavy dependence on borrowed funds and a larger fixed interest burden.

Total assets to debt ratio = total assets ÷ debt. The higher it is, the better covered the long-term lenders are.

Proprietary ratio = shareholders' funds ÷ total assets. It shows the share of assets financed by owners; a higher ratio means greater long-term safety for creditors.

Interest coverage ratio = profit before interest and tax ÷ interest on long-term debt (in times). It shows how many times interest is earned; a high figure reassures lenders that interest will be paid even if profits fall.

• Inventory turnover = cost of revenue from operations ÷ average inventory. A higher figure means faster-moving stock; a very high one can mean stock too thin to meet demand.
• Trade receivables turnover = credit revenue from operations ÷ average trade receivables. Higher means quicker collection.
• Trade payables turnover = net credit purchases ÷ average trade payables. Higher means suppliers are paid quickly; lower means the firm takes longer credit.
• Fixed asset turnover = revenue from operations ÷ net fixed assets.
• Net asset (capital employed) turnover = revenue from operations ÷ capital employed.
• Working capital turnover = revenue from operations ÷ working capital.

All are in times. Revenue from operations is net of sales returns; credit purchases are net of purchases returns.

• Gross profit ratio = gross profit ÷ revenue from operations × 100.
• Operating ratio = (cost of revenue from operations + operating expenses) ÷ revenue from operations × 100.
• Operating profit ratio = operating profit ÷ revenue from operations × 100 = 100 − operating ratio.
• Net profit ratio = net profit ÷ revenue from operations × 100, computed on profit before tax or on profit after tax as the question asks.
• Return on investment (return on capital employed) = profit before interest and tax ÷ capital employed × 100.

Gross and operating ratios ignore non-operating items; the net profit ratio includes them. Return on investment uses profit before interest because capital employed includes the lenders’ money.

Missing figures. Turn each given ratio into an equation (for example, current assets = 2.6 × current liabilities), solve in a chain, and finish by recomputing every given ratio from your answers.

Interpretation. Compare each ratio with a benchmark (2 : 1, 1 : 1), with earlier years and with similar firms; read the families together (a rising gross profit ratio with a falling net profit ratio points to expenses below gross profit).

Limitations of ratio analysis:

• based on past, historical-cost figures; price-level changes are ignored;
• qualitative factors are left out;
• firms may use different accounting policies, so comparisons can mislead;
• year-end figures can be window-dressed;
• there is no universally correct value for most ratios, and a ratio is only as reliable as the statements behind it.